The investors are affected by many behavioural biases. All the investors are hit by them, at some point or the other, in their profession. The intensity varies with the personality types and the risk profiles.
The behavioural biases can be cognitive or emotional. The cognitive biases are caused by the tendency to think or act in a specific way and the emotional ones are caused by the tendency to take actions based on feelings, rather than facts.
Michael Mauboussin Tips From Great Investors [Pt.2]
This is the second part of a short series on Michael J. Mauboussin's research document reflecting on 30 years of Wall Street analysis published in 2016. Q3 2020 hedge fund letters, conferences and more The document outlined Mauboussin's observations of successful investors throughout his three decades on the Street. This article starts at point six. Read More
One of the most common emotional biases is the Status Quo Bias.
Status Quo Bias
Status Quo is the behavioural condition which makes an individual stay where he is. These individuals prefer their things, situations and conditions to remain the same. In essence, status quo bias is a more intense version of the anchoring effect.
The individuals with the status quo bias are fearful of the unknown future, and they prefer not to change the circumstances, so they do not have to face the unknown. The known present gives them a sense of comfort, security and solace and they like the things to remain the way they are.
This behavioural bias turns out to be quite detrimental to the investors, in particular. The investors with status quo bias resist any change, even if it is financially optimal to do so. They tend to accept the current situation and default to the same judgement every time. This includes holding on to a current stock and not selling it inspite of the losses it is generating.
Causes of Status Quo Bias
The primary reason behind the status quo bias is the resistance to change. Many investors do not find it acceptable to change their positions, strategies and other aspects. They do not find it necessary to put in the extra efforts to move from the known territory to the unknown one. Changing the status quo requires a lot of decision-making, and those with decision fatigue prefer not to get into the mind-boggling exercise.
On the other hand, apart from the cognitive and emotional reasons, some investors often have practical reasons for staying where they are. Changes in the personal finance and investing involve high transaction costs, which can be avoided by the status quo.
At the same time, status quo bias is also supplemented by other behavioural biases, like the loss aversion bias and the endowment effect. The investors with loss aversion bias fear losing money, more than taking risks to gain rewards. In the efforts to prevent losses, they prefer to keep their positions and investments the way they are. Similarly, the ones with endowment effect value their belongings more because they own it. This makes it less likely for them to part with these investments and hence, remain status quo.
Effects of Status Quo Bias
Simply put, the status quo bias leads to financial inertia. The investors with status quo bias end up remaining where they were, even when there were enough chances and opportunities for them to upgrade their economic conditions. These investor fails to explore new opportunities.
As a result of the status quo bias, the investors also end up maintaining a portfolio that is far away from its optimal allocation in the present. In the past, the portfolio could have been optimum, profit-generating and ideal, however, in the rapidly changing economic and financial environment, the same portfolio may not remain viable and profitable; especially with other investors updating their portfolios way more frequently.
Not only does status quo cause risk aversion, it may also cause excessive risk-taking, at times. When an investor is holding on to the investments that are not appropriate for his risk and return profile, he is either taking excessive risks or being too conservative. Both the situations lead to less than optimal outcomes.
How to Overcome Status Quo Bias?
Status quo is an emotional bias, and it is too deep-rooted to be eliminated radically. However, with proper education and examples, the investors can be made to review the implications of their bias and judge by themselves. The investors can be shown the underperformance of a portfolio with inappropriate assets and asked to observe the difference as compared to a timely updated portfolio.
Another effective strategy to overcome the status quo bias is to keep evaluating the investments and purchases on a regular basis. This can be done by following a disciplined and active approach of portfolio management and investing. Rebalancing of the portfolio at regular intervals ensures that the investor does not remain stuck to where he was, and he realigns his investments with the market and his financial needs and preferences.
It is understandable that making frequent changes to the portfolio and investments is a time-consuming and gruelling task. However, the status quo bias can still be avoided to remain current with the financial markets and circumstances, and grow.